What Bomb Buried in Obamacare?

I'm very confused by this piece from fellow Forbes contributor Rick Ungar. He tells us that there's a bomb buried in Obamacare (or more formally, the Patient Protection and Affordable Care Act) and that it's just gone off. Further, that it will mean the end of private, for profit, health care insurance on any large scale: whatever remains will be just a luxury item for those who like to beat the queues as such insurance is in the UK where we have the NHS.

That would be the provision of the law, called the medical loss ratio, that requires health insurance companies to spend 80% of the consumers’ premium dollars they collect—85% for large group insurers—on actual medical care rather than overhead, marketing expenses and profit. Failure on the part of insurers to meet this requirement will result in the insurers having to send their customers a rebate check representing the amount in which they underspend on actual medical care.

This is the true ‘bomb’ contained in Obamacare and the one item that will have more impact on the future of how medical care is paid for in this country than anything we’ve seen in quite some time. Indeed, it is this aspect of the law that represents the true ‘death panel’ found in Obamacare—but not one that is going to lead to the death of American consumers. Rather, the medical loss ratio will, ultimately, lead to the death of large parts of the private, for-profit health insurance industry.

Why? Because there is absolutely no way for-profit health insurers are going to be able to learn how to get by and still make a profit while being forced to spend at least 80 percent of their receipts providing their customers with the coverage for which they paid.

What confuses me here is that in a competitive market it's entirely normal for an insurer to have a loss ratio higher than 80%. There are plenty of entirely profitable and growing insurance companies that have loss ratios over 100%. So I cannot really understand why the law insisting on an MLR of 80% (or 85% in the large group market) is going to cause all for profit insurance companies to fall over.

This idea of a loss ratio over 100% is a little odd, of course, but allow me to explain it. There are two entirely different income streams for an insurance company. One is the premiums that are paid in: we can all see that one and understand it. The second is the hidden one that most don't understand is there: that's the investment income gained from having those premiums in between their collection and the need to pay them out again on a claim.

Depending upon what type of insurance policy you're writing that gap, the time you get to hold the money for, can be really quite large. Say, just as a wild example, you're writing hurricane insurance (whether or not hurricane insurance actually exists or not is irrelevant to the example). Even if you're writing it for houses on the Outer Banks of the Carolinas you still only expect any specific house or area to get hit once every few decades. So you get to hold onto, and invest, those insurance premiums for decades. A time in which some fairly juicy investment returns can be made.

At the other end we've parts of health insurance. A goodly part of health insurance isn't in fact insurance: it's assurance. We all do go to the doctor, all do get our shots, check ups and so on and this is a claim to the insurer. So they might only have our premiums for a few months at most before we claim it back in the form of health care. But another part of health insurance really is insurance: we're buying insurance against a horrible car smash, a case of cancer. And we might never claim on that at all: the insurers thus being able to keep that money again for decades, decades in which substantial investment income can be made.

Now, we the customers don't know much about this investment income: but everyone else running an insurance company most certainly does. So, as I've pointed out elsewhere, it's entirely normal for a car insurance company to be paying out more than 100% of the premiums every year. A loss ratio of over 100%, let alone 80%.

For as everyone running an insurance company knows, those profits from investment are there, so premiums are cut in competition to gain access to that cashflow and the profits that can be made from managing that cashflow.

So, that's the background. It's simply not unusual for an insurance company to have a high loss ratio indeed, the more competitive the market is the higher we expect it to be as investment income is used to subsidise premiums. For the flow of premiums is what makes the investment income possible.

However, as above, this does vary dependent upon what type of insurance is being written and thus how long the insurer gets to play investment banker with the premiums. Perhaps so much of US health insurance is in fact assurance that there's not much such profit to be made? And thus the loss ratios will be quite low and thus strongly affected by the new law?

No, I didn't know either until I went and looked it up. But here's the GAO report on what are the medical loss ratios for US health care insurers.

It's the two charts on pages 12 and 14 that you want to look at (and darn this new technology thing that prevents me embedding them!) and as you can see a majority of insurers are well over the 80 and 85% targets already.

From 2006 through 2009, insurers’ traditional MLR averages generally exceeded the PPACA MLR standards—80 percent for the individual and small group markets and 85 percent for the large group market.

We should note that the new, PPACA MLR standards are actually easier to pass than the traditional method of calculating MLRs.